Bank Consolidation Will Center on This U.S. City

NEW YORK ( TheStreet) -- The consolidation of the U.S. banking industry is gaining steam, and Chicago may be the ripest major market for takeovers, according to KBW analyst Christopher McGratty.

Thousands of small banks are trying to scrape together decent profits amid low interest rates and weak loan demand.

There were about 7,150 banks in the U.S. as of Dec. 31, declining from 9,321 at the end of 2007, according to data provided by Thomson Reuters Bank insight. There were 465 bank failures during that period, and many more banks were forced to sell because of low credit quality and an inability to raise sufficient capital to remain independent.

Still, the health of the banking industry has clearly improved, as the dramatic slowdown in bank failures and the rally in bank stocks have shown. There have been only three bank failures this year, following 51 closures during 2012. The peak was 2010, when 157 institutions were shuttered by regulators.

But all is not well for thousands of community banks, facing low interest rates on which it's hard to make a profit, weak loan demand and expensive, ballooning regulations.

According to the FDIC's most recent data, aggregate industry profitability has rebounded, with a return on assets of 1.02% for the first three quarters of 2012, and a return on equity of 9.02%. Those figures have improved steadily since 2009, when the industry had an aggregate operating loss.

But industry figures can be deceiving because they are so heavily weighted to the largest banks. According to preliminary year-end data supplied by Thomson Reuters Bank Insight, there were 1,215 banks with returns on average assets (ROA) below 0.25% during 2012, while 1,317 had returns on average equity (ROE) of less than 2.5%. Those are weak returns, and smaller banks' boards tend to be dominated by local investors, who eventually will feel the need to cash out of lower-paying investments and seek greener pastures.

Potential buyers' improved earnings and capital levels may also spur industry consolidation. Looking at the FDIC's aggregate data, the industry's core capital ratio -- or Tier 1 leverage ratio -- was 9.28% as of Sept. 30, increasing from 7.97% five years earlier.

KBW analyst Christopher McGratty, in a report Wednesday, said earnings pressure on banks "are real and will likely continue, especially if we stay on the path of low rates and slow economic growth. However, with greater confidence in bank balance sheets today, we view the current environment as nearly ideal for a pickup in consolidation."

"Looking ahead, estimating the ultimate number of banks that will be consolidated over the next cycle is an often-asked, but nearly impossible, question to answer," McGratty wrote. "However, with virtually no new bank charters granted in 2011 or 2012 (versus median of about 150 annually from 1990-2008), a more recent but seemingly structural move toward fewer and smaller branches, and continued headwinds impacting group profitability, all signs seem to be pointing toward fewer banks in the coming years."